A week before emerging-market turmoil, a prescient exchange on just how much the Fed cares

The last seven days has been a glaring example of fallout from the cross-border carry trade. That’s the sort of trade, well known in currency markets, where investors borrow funds in low-rate countries and invest them in higher-rate ones. Some $4 trillion is estimated to have flooded into emerging markets since the 2008 financial crisis to profit off the ultra accommodate policies of the U.S. Federal Reserve, Bank of Japan, European Central Bank and the Bank of England. Now that central banks in developed economies are looking to reverse course and eventually raise rates, that carry trade is unraveling fast, resulting in the brutal sell-off in emerging markets such as Turkey and Argentina over the last week.

The Fed’s decision on Wednesday to keep cutting its stimulus effectively ignores the turmoil in such developing countries. And while the Fed may well be right not to overreact, it makes one wonder just how much attention major central banks pay to the carry trade and its global effects — and it brings to mind a prescient exchange between some of the brightest lights of western economics, just a week before emerging markets were to run off the rails.

On January 16, minutes before Ben Bernanke took the stage for his last public comments as Fed chairman, the Brookings Institution in Washington held a panel discussion featuring former BoE Deputy Governor Paul Tucker, Harvard University professor Martin Feldstein and San Francisco Fed President John Williams. They were asked about the global effects of U.S. monetary policy:

Williams:

“These countries have been affected, no question, affected in a major and important ways by these flows and have adapted their policies and their approaches to better insulate them from some of those effects… That said, at the end of the day, we live in a modern and global financial system.. Monetary policy in the U.S. obviously has effects outside the U.S. and we need to study those, we need to understand those, and we need to coordinate or communicate more effectively with our colleagues around the world.”

Feldstein:

“The only thing I would add is that the Fed doesn’t take those effects on other countries into account.”

Tucker:

“Well they should to the extent that there is a risk that it will flow back to the United States.” The cross-border currency carry trade “has been ignored in the economics profession and central banking for far too long. And it doesn’t just flow one way — it can bounce back.” The recent euro crisis “demonstrated that the linkages of the world don’t just run from here to there — they can flow back as well.”

It would take a serious escalation of today’s turmoil to wash back on American shores in a way that imperils the U.S. economy. But if it does – say, if the strengthening U.S. dollar brings on disinflation – you can be sure the Fed will act.